Potential Gift Tax Pitfalls When Three Parties are Involved in a Life Insurance Situation

Planners should red flag every situation where one party owns a life insurance policy on the life of another and the proceeds are payable to a third party (commonly known as the “Goodman Triangle” as a result of a well-known court case4 ). Sometimes, in business cases, the situation results in income tax problems, while in other situations it causes serious and unexpected gift tax problems. Indirect, but nevertheless taxable, gifts can occur where one party (e.g., a wife) owns a policy on the life of a second party (e.g., a husband) and makes the proceeds payable to a third party (e.g., the couple’s children).

Example. Charlee Sterling purchases a $1,000,000 policy on the life of her husband Rob and names their son Max as beneficiary.

At the death of the husband, the wife is deemed to have made a gift to her son in the amount of the $1,000,000 policy proceeds. The reason for this harsh result is this: Generally when a policy-owner-client names a beneficiary (other than the client’s estate) as beneficiary, the client is technically making a gift to that party. The reason no gift tax is imposed at that moment, in most cases, is because that gift remains incomplete until the policyowner no longer has the right to change that beneficiary designation. Retention of a power to revoke a gift renders the gift incomplete and therefore not taxable until the power is released or lapses.

Conversely, if the policyowner makes the policy beneficiary designation irrevocable, at that moment, a completed gift has been made. From that point on, every time a premium is paid, a further gift is made. Worse yet, since the gift is contingent upon the insured’s death, it would be considered a future-interest gift and therefore will not qualify for the annual exclusion.

When there is a three-party situation, the gift becomes irrevocable when the insured dies. The gift that the policyowner makes when a third party is designated as beneficiary changes from uncompleted to completed at the insured’s death. Thus, a taxable event occurs in that instant. The amount of the gift is the entire amount of proceeds paid to someone other than the policyowner. So, in the example above, the wife Charlee is deemed to be making a gift of $1,000,000 to her son Max at the moment of her husband’s death.

The following common examples of the gift tax version of the three-party situation will serve both as a warning and a review for planners:

Example 1. A wife owns a policy on her husband’s life. She names her children as beneficiaries. When the husband dies, she is deemed to have made a gift to the children in the amount of the entire policy proceeds.

Example 2. A wife purchases a policy on her husband’s life. She revocably names a trust she previously established as beneficiary of the proceeds. The trust provides that income from trust assets is to be paid to her husband for life, but upon his death principal is to be split in equal shares between the couple’s children. A simultaneous death provision states that if the couple dies simultaneously, the wife would be presumed to have survived her husband. If the husband dies first or the couple does in fact die simultaneously, the wife will be deemed to have made a gift of the proceeds to her children. Had the trust been irrevocable, the annual premiums rather than the proceeds would have been the measure of the gifts.

Example 3. A husband creates a revocable living trust. Under the terms of the trust, income was payable to his wife for life. At her death, any principal in the trust was to pass to the couple’s children. The wife purchases a life insurance policy on her husband’s life and names the revocable trust established by her husband as beneficiary. Upon the husband’s death, the wife is deemed to have made a completed gift to her children equal to the entire proceeds less the present value of her right to a life income from the trust. If the wife had named the trust as irrevocable beneficiary, a completed gift would have been made at that time, but it would have been significantly less than the value of the proceeds.

The solution to all of the three-party problems is relatively simple: Where one party will purchase a policy on the life of another from an insurer, name the purchaser as both policy owner and beneficiary.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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